Plan takes longer view but silence on banks is strange

ANALYSIS:The pre-announcement of future spending and tax plans should reduce fiscal uncertainty but its silence on the banks is a glaring omission

AT ONE level, the publication of the Government’s four-year plan should not be viewed as an unusual event. Indeed, under the proposed new economic governance regime for the European Union, such multi-year plans will become a normal part of the political cycle. In principle, a multi-year plan has many advantages, since the pre-announcement of future spending and tax plans should reduce fiscal uncertainty and provide a better basis for private-sector spending and investment decisions.

A multi-year plan is also helpful in setting out a government’s philosophy in terms of tax and expenditure levels and its targets for the delivery and reform of public services. Of course, this is best laid out at the start of a government’s term of office (ideally, reflecting the principles laid out in electoral manifestos), rather than at the tail end of an administration.

However, the reality is that many details in the current plan can be revisited once a new government is elected in 2011. That said, the current plan may still play a useful role in providing a baseline that can help frame the details of the upcoming electoral debate.

Since the overall fiscal targets will be broadly fixed under the terms of the upcoming international agreement with the EU and IMF, the debate will not be about the overall aggregates but rather about how to vary the mix of spending and tax measures relative to the path laid out in this plan (with further details to be specified in the December 7th budget).

In relation to the negotiation of the EU/IMF package and international market sentiment, this plan serves an important but limited role. It shows how the current Government would deliver the €15 billion fiscal adjustment, which is necessary for the deal to be concluded. The international organisations are likely to be quite relaxed about revisions to the plan by the next government, so long as the overall budget targets are met.

In addition, it specifies how the Government seeks to deliver the growth projections that were previously published in early November and how it will improve the funding environment for the Irish Government and the Irish banking system. The growth rate is a key issue for the international investor community, which is trying to work out whether the Irish economy will grow sufficiently quickly to make its public and private debt levels sustainable. Similarly, increasing domestic sources of funding is viewed as a key step in reducing dependence on external investors.

In terms of pro-growth policies, the main message in the document is that the Government stands behind its longstanding pro-export pro-business strategy. The plan reaffirms the commitment to the 12.5 per cent corporate tax rate, while also seeking to protect the budgets for the IDA, Enterprise Ireland and research and innovation.

It also promises a range of measures to further support both foreign-owned and indigenous export firms. In relation to the domestic sector, it recognises the importance of reducing the domestic cost base, such as rents and utilities.

In addition, it seeks to reduce labour costs by a reduction in the minimum wage and revisiting other types of regulated wages in the economy. Other labour market reforms include a pay reduction for new public sector employees and a greater focus on “activation” policies to limit the risk that those losing jobs during this recession are permanently exiled from employment.

Of course, such supply-side policies cannot be expected by themselves to deliver growth during a major domestic demand slump. However, these policies are essential in avoiding the persistence of long-term unemployment over the next decade and have a bigger payoff in a highly open economy, in view of the importance of wage costs and a flexible labour market in determining medium-term export potential and scope for import substitution with domestic alternatives.

Accordingly, such policies will be viewed favourably by the IMF and European Commission, which are very concerned with the path for potential output over the longer term.

The need for fiscal austerity has limited the Government’s ability to directly influence short-term growth through demand-stimulus policies. Although the Opposition parties have several ideas about deploying the National Pension Reserve Fund (NPRF) to leverage domestic investment by State-owned companies or through the creation of a State bank, the Government has rather chosen to mainly allocate the NPRF funds to improving the funding situation for the Irish Government. By allowing the NPRF to purchase Irish government bonds, this provides a domestic source of demand for Irish sovereign debt.

Other initiatives also raise domestic demand for Irish debt, through a revised regime for private-sector pension funds, a new Consumer Price-Indexed government bond and a shorter-duration special savings bond (although the bond schemes may in part just substitute for deposits in the domestic banking system).

In view of the dire funding situation in international markets, raising domestic demand for Irish debt may be seen as a more pressing use of NPRF funds than more speculative ventures that could be viewed by international investors as unwisely raising the explicit or implicit liabilities of the Irish sovereign debt. In addition, there is also some increase in the NPRF’s role in funding domestic infrastructural projects, such as the installation of water meters.

In relation to boosting short-term domestic demand, one standard policy approach is to pre-announce a future increase in VAT, thereby encouraging consumers to bring forward planned expenditures. This is indeed part of the plan but the VAT increase will only be incrementally increased in 2013 and 2014. A bigger boost to domestic demand in 2011 could have been achieved by pre-announcing a one-step increase in VAT for 2012.

Overall, however, the plan does not seek to quantify the impact of its policy proposals on projected GDP growth over 2011-2014. While medium-term macroeconomic modelling is necessarily imprecise, it is disappointing that the plan did not specify in more detail the extent to which these pro-growth proposals are expected to improve growth performance within the near-term confines of the 2011-2014 period.

Furthermore, the plan is silent on the impact of the banking crisis on projected growth rates. While much will turn on the resolution plans that are set to be announced in the coming days, some discussion of this key issue would have been welcome.

Space limitations mean that I can only cover the composition of the fiscal adjustment in a limited way. On the spending side, a key assumption is that productivity in the public sector will be significantly increased through the implementation of the Croke Park agreement. Rapid progress on this front in early 2011 will be necessary if the alternative route of further cuts in public sector pay is not to be reopened for the 2012-2014 phase of the plan.

There is a further sizeable reduction in the capital budget, which is appropriate in view of the reduction in tender prices and the closing of the infrastructural deficit in recent years.

On the tax side, the rolling back of allowances and credits will be painful for lower-earning workers but a broadening of the tax base is a key structural reform for long-term sustainability, as is the projected increase in the pension age. However, the limited plan for a property tax seems under-ambitious.

In summary, the publication of a four-year government plan is a welcome innovation that should become part of the routine political process. By providing a longer horizon for fiscal planning, it should improve the quality of the fiscal process in Ireland.

In the future, such plans will be evaluated and monitored by an independent budgetary council, in addition to the critical role played by the opposition parties. At a procedural level, this is one positive step towards a new and improved political system.

Philip Lane is professor of international macroeconomics at Trinity College, Dublin, and founder of The Irish Economy blog, irisheconomy.ie

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